You have asked me to talk
about tax, and I want to begin with two real life
stories.

When President Bill Clinton was in office, he
phoned the tennis champion Venus Williams to congratulate
her on her win at the US Open. The president got more than
he bargained for. Williams told him she had worked hard to
win the prize money, and she deserved to keep more of it.
"I'm a good citizen", she said. "Can you lower my taxes
please?"

About the same time a story in the headlines was
the departure to London of the French model Laetitia Casta,
said to be the most beautiful French woman alive, partly to
escape France's high tax rates. The Economist calculated
that a single woman (or man) earning US$100,000 or more was
more than US$11,000 better off in London than in Paris. The
Paris newspaper Le Monde lamented France's brain drain of
entrepreneurs and high achievers. "You can't have a dinner
party without a guest mentioning the exodus [of tax
refugees] to Great Britain", it wrote.

These stories bring
out two key points. One is that high taxes create
incentives that discourage productive effort, and as a
result average incomes in a country are lower than they
could be. The other is that if people think they are paying
too much tax they will take steps to avoid it, ultimately by
leaving the country. These were among the messages of the
report of the 2001 Tax Review chaired by Rob McLeod.
Regrettably, the government has so far disregarded
them.

Economists think that incentives matter because they
alter people's behaviour. William Easterly, a former World
Bank economist and specialist in economic growth who visited
New Zealand last year, has gone as far as to say that
economics is only about incentives: "All the rest is
commentary".

When it comes to incentives, the government
seems to present a strange case of 'doublethink' – George
Orwell's term for the ability to hold two contradictory
beliefs at the same time.

Much of the time the government
seems to think that incentives don't matter. We see this in
a variety of areas. When it came to office, the government
was concerned about the levels of student debt. It reacted
by making loans interest-free while students are studying,
presumably thinking this would not alter incentives to
borrow. Of course it did, and student debt has mushroomed.
Similarly, the government made access to sickness and
invalids benefits more lenient, seemingly in the belief that
people would only apply for such benefits if they genuinely
needed them. It seems to be puzzled by the steep rise in
the numbers of people on these benefits. At other times
the government obviously thinks that incentives are
important. For example, in the name of economic development
it is handing out subsidies to businesses on a scale that we
have not seen since the Muldoon days. The most recent is
the subsidy to big-budget movies. Plainly the government
believes that the favoured firms or industries will increase
investment, production and job creation in response to these
incentives. And it doesn't seem concerned about favouring
the so-called 'rich' – whether large multinational
companies, America's Cup promoters or Hollywood moguls.

We
see the same 'doublethink' when it comes to tax. On the one
hand the government understands that incentives matter. Why
would it have increased taxes on cigarettes and so-called
light spirits if it didn't think they would discourage
smoking and teenage alcohol consumption? Why is there
currently talk about a tax on foods with a high fat content?
And the government has shown itself to be one of the world's
most fervent believers in the idea of taxing fossil fuels in
the interests of curbing CO2 emissions to reduce global
warming.

Yet when it comes to work, saving, investment and
risk-taking – the things that matter for personal incomes
and economic growth – the government is largely in denial
about the incentive effects of taxation. Ministers are wont
to say that they wouldn't work any harder themselves if they
paid less tax. Finance minister Michael Cullen usually
asserts that there is no evidence that the level of
government spending and taxation affects economic
growth.

Simple commonsense calls these claims into
question. If wages are taxed at 100 percent, how many
people would turn up to work? Perhaps some ministers would
attend cabinet meetings, but I think we would soon see
factories and offices shut and a booming underground
economy. And if a 100 percent tax rate would put an end to
most formal work, isn't it likely that a tax rate of, say,
70 percent or 50 percent or 30 percent would have some
effect? My example is not fanciful: at one stage Britain
had a top tax rate of 98 percent and New Zealand a 66
percent top rate. Even today, the combination of a top
income tax rate of 39 percent and a goods and services tax
of 12.5 percent means an effective top tax rate of close to
50 percent on income spent in New Zealand. Because of the
disincentive effects of high tax rates there has been a
worldwide move to lower them in the past 20 years.

The
same thing goes for savings. Consider the position of
someone who puts $1000 on a term deposit of 6 percent for a
year. Gross interest of $60 is reduced to $40 after tax
with a 33 percent tax rate. The real value of the $1000
deposit is reduced by $25 over the year with inflation at
2.5 percent – around the average of the past three years.
So our saver winds up with only a real gain of $15 or 1.5
percent on a $1000 deposit – not a great incentive to
save.

To be fair, the government occasionally acknowledges
some of these things. Dr Cullen recently told a Grey Power
conference that if taxes had to go up in the future to fund
superannuation, that would damage the economy. Since coming
to office he has talked about some form of concessional tax
treatment for saving. But when people talk tax concessions
they are really talking about lower taxes on some activity
they happen to favour. They understand that higher taxes
are harmful.

All this suggests that, to put it as mildly
as I can, the government's attitudes to incentives – and to
the incentive effects of taxes in particular – are a bit
incoherent. And because incentives matter for economic
growth and the government says growth is its top priority
objective, the debate about incentives, taxes and the size
of government is a very important one.

A comment by
Professor James Gwartney, a leading researcher on economic
growth, has been much debated over the past couple of years.
Gwartney wrote:

… New Zealand is still a big government
welfare state. Government spending [central plus local
government] continues at nearly 40 percent of GDP, a figure
much too high for maximum growth. I do not know of any
country that has sustained per capita income growth of 4
percent or more with that level of government spending.

Dr Cullen asserted that claim "is simply wrong".
However, the Business Roundtable has shown that among
Organisation for Economic Cooperation and Development (OECD)
countries, only Luxembourg, which is hardly comparable to
New Zealand, has achieved that feat. It follows that if New
Zealand is to grow at the rate which the government is
targeting, government spending and taxation need to be
reduced to well below the current levels as a proportion of
the economy. It also follows that any serious discussion of
lower taxes, whether selective or across-the-board, has to
start with government spending. Generally speaking, what
any government spends has to be raised as tax revenue. Thus
there's no point arguing for lower taxes if you're not
prepared to argue for lower government spending as well.
And when it is proposed that government spending should be
reduced to, say, 30 percent of gross domestic product (GDP),
the immediate political question is 'What government
spending are you going to cut?'

In fact, the answer to
that question is not difficult. Indeed a credible answer
would be none at all: a policy which simply held the rate of
growth of government spending below the growth rate of the
economy would see a steady fall in the government spending
ratio. A large part of the fall in Ireland's government
spending ratio from over 50 percent of GDP in the late 1980s
to around 30 percent today was achieved in this way. Some
US states have institutionalised a policy rule along these
lines: Colorado, for example, limits increases in government
spending to the inflation rate plus population growth.

In
addition, there is an enormous amount of government spending
that is wasteful and badly targeted, and much could be done
to reduce it. The OECD has commented that 95 percent of
government spending in New Zealand is not properly reviewed.
Better growth, labour market and welfare policies could
significantly reduce welfare spending. Much spending simply
involves wasteful 'churning' of income among people in upper
and middle income categories who could pay for many
government services themselves given lower taxes. More
could be saved by getting the government out of commercial
activities and eliminating business welfare.

The United
States, Australia and Ireland, which all have government
spending ratios around the 30 percent level, demonstrate
that a smaller size of government is not only feasible but
desirable. All have had faster growth rates and achieved
much higher per capita incomes than New Zealand. And many
would argue that even in these countries governments have
expanded well beyond their proper limits.

With a lower
level of government spending, there would be ample scope to
cut taxes substantially, as these countries have done. In
my view the McLeod Review correctly identified the
priorities for tax reform in recommending moves to a lower
and flatter income tax structure. Other McLeod proposals,
including a limit on the total liabilities of any individual
taxpayer, lower taxes on foreign investment and the
scrapping of excise taxes, are desirable as well.

Whenever
political parties propose moves to cut top tax rates and
flatten the tax scale, the cry goes up that they want to
'favour the rich'. We saw that with the Bush
administration's tax proposals last year. Yet the United
States and many other countries around the world are
continuing to move in this direction. Even Germany is
cutting its top rate to 42 percent, only just above New
Zealand's 39 percent level.

I think the response to such
criticisms is again relatively easy. First, any party that
is seriously committed to growth must reflect that priority
in its tax policy. The taxes that are most damaging to
growth are generally those with the highest effective
marginal rates (including those that apply when welfare
benefits are abated). The economic damage – what economists
call the marginal excess burden of tax – rises exponentially
as tax rates increase. Using reasonable assumptions, it can
be shown that if the marginal excess burden is 10 percent
with a 10 percent tax rate (meaning that it costs $1.10 for
every extra dollar of revenue raised), it rises to nearly 60
percent with a tax rate of 40 percent. Yet the government
is saying that next year, if circumstances permit, it plans
to reduce lower tax rates (and so widen the tax scale
further). This is another case of the government favouring
income redistribution over wealth creation and economic
growth, despite its stated priorities.

Secondly, there are
strong arguments on grounds of fairness for a broadly
proportional tax rather than a steeply progressive one. The
American economist Steven Landsburg illustrates one of them
in his book Fair Play. He takes the example of three
people each with wooded lots who need to build shelter for
themselves. A and B are accomplished woodsmen but C is not,
and risks perishing without help. A builds a splendid house
but B, being content to commune with nature, builds a simple
lean-to. Now the question is, if A and B are in any sense
obligated to help C, is one more obligated to do so than the
other? Surely not, Landsburg concludes – both are equally
competent woodsmen. Yet the principle behind the
progressive tax code would have A, who worked long hours and
created a valuable asset, contribute more than B who spent
his time picking wildflowers.

Or consider two people
who are equal in all respects including their earning rate
except that A values travel highly and spends 3 months each
year abroad whereas B works full time for the whole year.
With a single rate of tax B's tax bill is a third higher
than A's, but with a progressive rate it is more than a
third higher. Why is this fair?

It turns out on more
rigorous analysis that the idea of a progressive tax is
based on envy, not fairness. People rightly think that
those on higher incomes should pay more tax, but that is
exactly what happens with a flat or proportional tax. As
the Kemp Tax Commission in the United States put it:

If
one taxpayer earns ten times as much as his neighbour, he
should pay ten times as much in taxes. Not twenty times as
much – as he would with multiple and confiscatory tax rates.
Not five times as much – as he might with special loopholes.
Ten times as much income, ten times as much tax. That's the
deal.

Landsburg adds that a fair deal would also recognise
the principle that there is some limit to a person's social
responsibilities. His own "gut preference" is that nobody
should ever be required to pay more than five times the
average tax bill. That is considerably less than the McLeod
Review proposal for a tax cap of $1 million a year. People
facing high levels of tax tend to vote with their feet –
whether they are Laetitia Casta or some of New Zealand's
most talented entrepreneurs. The government loses tax
revenue and the country loses their skills. Only envy or
spite, not fairness, can explain opposition to such a
policy.

Thirdly, there is a raft of practical advantages
from moving towards a lower and flatter tax scale. Most of
the problems of complexity, cost, distortion and abuse come
from having a wide spread of rates. Problem areas such as
the tax treatment of company income, fringe benefits,
capital gains, housing, superannuation, income splitting and
many others would all be ameliorated with a lower and
flatter scale. It is far better to aim for such a tax
structure than to go in for selective tax concessions.
These benefit favoured categories of taxpayers but mean
higher taxes for everyone else. The tax system has grown in
complexity since the tax reforms of the 1980s, and Dr
Cullen's moves to increase the top rate to 39 percent
resulted in 47 more pages of tax legislation. We have now
reached the absurd point where the government in its last
budget announced that it would subsidise small employers to
compensate for the costs of handling some of the tax
obligations it is imposing on them! The motto in tax, as in
many other areas, should be 'Keep it simple, stupid'.

Like
the case for a single rate of GST, the case for a single
rate of income tax is very powerful. Steeply progressive
taxation was a Marxist idea, and deserves to be buried with
Marx. Politicians such as Jim Anderton still espouse it but
Russia and the Ukraine – countries which long maintained a
socialist culture of envy – now have maximum individual tax
rates of 13 percent, and Slovakia is considering the
adoption of a flat tax with a 19 percent rate. The new rate
in Russia has been in effect for two years, and government
revenue from personal income taxes has more than doubled.
Hong Kong has had a tax on wages and salaries of 15 percent
which is being raised to 16 percent. Singapore is cutting
its top personal and company rates to 22 percent.

Defenders of big government and high taxes, particularly
on the left of politics, couch their arguments in terms of
concerns for public services and the poor. What I have
tried to show in the brief compass of this talk is that
these arguments need to be stood on their head. Both
concerns are better dealt with by focusing squarely on
economic growth, which implies smaller government with lower
taxes.

No country can grow fast with big government. We
need governments, but we need them to be focused on their
indispensable core roles so as not to crowd out personal
choice and blunt incentives for work and enterprise.
Countries with smaller governments such as the United
States, Australia, South Korea, Singapore and Ireland are
out-performing the high tax states of Europe. Irish deputy
prime minister Mary Harney has said that "low taxes are the
central reason for Ireland's economic success" (emphasis
added).

The disparities are dramatic. A recent study by
a leading economist found that tax accounts for most of the
30 percent gap in average income between the United States
and France. Not only do people enjoy higher personal
incomes in wealthy countries but they enjoy more and better
public services as well. Ireland is spending far more on
services such as health and education than it was a decade
ago thanks to its phenomenal economic growth and the larger
revenues it generated even with lower taxes. As President
John Kennedy pointed out when he cut taxes in the United
States in the 1960s:

It is a paradoxical truth that tax
rates are too high today and tax revenues are too low – and
the soundest way to raise revenues in the long run is to
cut rates now.

The lesson is simple: it's better to have
a smaller slice of a large and fast-growing pie than a big
slice of a small and slow-growing one.

The arguments about
tax and the poor are similar. It's perfectly true that cuts
to top rates benefit better-off people initially, and may
even widen income disparities. But they do not only benefit
better-off people. Lower marginal tax rates fuel overall
growth and strong growth does more for the poor than the
most aggressive income redistribution policy. This isn't a
trickle-down theory – there is no such theory in economics –
but simply standard economic teaching about growth.
African-Americans now enjoy a higher average level of per
capita income than New Zealanders not because of income
redistribution but because the United States is a much
wealthier country. If people are motivated by compassion
rather than envy, the plight of the least-well off should be
of greater concern than income disparities at any point of
time – especially because people move up and down the income
ladder over their lifetimes. So the tax game is not zero
sum: gains at the high end also work to the advantage of the
poor.

All this should be straightforward to anyone who
understands incentives. You don't need fancy economic
studies to work out what happens when incentives are
changed. If you subsidise something you will generally get
more of it – we saw that with Muldoon's supplementary
minimum payments for sheep. If you tax something, you will
generally get less – whether it is smoking or CO2 emissions
on the one hand or work, savings, investment and risk-taking
on the other. All that economic studies help clarify is
whether the reduction is a little or a lot. I don't know
whether Venus Williams is a budding tax expert but she seems
to have the right general instincts. She knows tax punishes
success, and if we want more success as a country we should
listen to her
message.

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